Category: Consumer

The I/O Fund initiated a new position in Affirm last week, here is Beth’s post on the forum announcing the decision and a brief discussion of what she liked about the name. In the discussion that follows, I dive deeper into the Affirm story and explain the key micro trends, how Affirm makes money, its recent financial performance and conclude with a discussion about its valuation relative to peers.

Affirm’s Opportunity

Affirm was founded in 2012 by current CEO Maksymilian “Max” Levchin, a co-founder of PayPal, along with Nathan Gettings, who was also a co-founder of Palantir Technologies. As Beth mentioned in her forum post, Affirm’s management team has deep connections in tech circles, which likely helped the company secure big partnerships with Shopify and Amazon in recent quarters. The company has ambitious goals of reinventing the financial ecosystem around consumer credit. Affirm explained in its Q3 10Q that it is “building the next generation platform for digital and mobile-first commerce” as it displaces legacy consumer payment methods such as debit and credit cards with a more consumer-friendly buy now, pay later (BNPL) payment option. The opportunity in front of Affirm is massive. As shown in the below slide from Affirm’s Q4 presentation, its total addressable market is $600 billion for U.S e-commerce sales, and Affirm has captured less than 1% of the market thus far.

Affirm’s core BNPL product is more consumer friendly than legacy products as it does not charge compounding interest or hidden fees, which are common throughout the credit card industry. Likely due to its consumer-friendly payment terms, BNPL products are among the fastest growing online payment methods in developed nations, and this growth is expected to continue. According to a 2021 Global Payments Study by FIS, BNPL accounted for 7% of European e-commerce payment methods in 2020, and BNPL is expected to double to 14% market share by 2024.

The 2021 Global Payments report also expects BNPL to take significant share in North America in the near term. The report projects that BNPL will grow 181%, from 1.6% of all e-commerce transactions in 2020 to 4.5% in 2024, taking share from credit and debit cards in North America. Furthermore, TD Bank’s Annual Consumer Spending Index showed that ~25% of millennials do not carry a credit card, likely to avoid being trapped by mounting credit card debt. With millennials and Gen Z being the largest percentage of the U.S. population, their avoidance of legacy credit cards and preference for BNPL products could help drive demand for Affirm going forward.

Another interesting trend in the 2021 Global Payment report showed that cashless societies tend to favor BNPL products. For example, Sweden’s economy is ~91% cashless, and 82% of the population makes purchases online. Interestingly, the most popular payment method for Swedish e-commerce shoppers is BNPL, which accounted for 23% of total e-commerce payments in 2020, above 19% share for debit cards and 11% share for credit cards. This trend may be a harbinger for other developed countries that are increasingly becoming cashless and shopping online.

Actual and estimated market share of BNPL in Europe and North America in 2020 and 2024

The continued rise of e-commerce will also benefit BNPL providers such as Affirm going forward. According to the US Department of Commerce, only ~13% of retail sales are online despite the rapid growth in recent years. The relatively low penetration of online retail sales suggests that there is still plenty of runway ahead for Affirm to continue to take market share from other legacy payment options.

The combination of rising e-commerce and mobile sales coupled with younger generations favoring BNPL over credit cards should support Affirm’s strong growth rate going forward. Consumers prefer Affirm’s BNPL products over legacy payment options because Affirm is a customer centric business. The company does not charge hidden fees or compound interest like most legacy financial products. By treating the customer right with simple payment terms, no hidden fees and an intuitive app, Affirm believes that it can continue take market share from legacy financial institutions.

How does Affirm make money?

Affirm’s revenue model is centered around both the merchant and the consumer. Affirm does well if these two parties do well, a symbiotic relationship that is different from the legacy model which benefits from high interest rates and hidden fees that punish the consumer.

The company makes money from merchants by charging a fee for helping them convert a sale and facilitating the payment. The fees vary per merchant agreement, but the fee is generally higher when interest-free 0% APR financing is used. Affirm claims that due to its superior risk models, which goes beyond traditional credit scores and also considers product level detail, the company approves 20% more consumers than its competitors. The higher rates of approvals benefits merchants by accelerating sales generation. We can also see that Affirm’s risk models are working well, as the company’s credit metrics have improved in recent quarters (discussed in greater detail below).

Affirm is also the demand driver for merchants, as the company’s proprietary data can help generate leads for merchants on its platform. Furthermore, Affirm’s BNPL products lead to higher average order sizes (AOVs) by financing large ticket items, which benefits merchants. Higher AOV also leads to higher fees for Affirm, benefitting its topline.

Affirm also makes money from consumers by charging simple interest on the loans that it facilitates. The company purchases loans from its bank partner that originate the loans for the company. These bank partnerships allow Affirm to focus on the technology while the banks focus on the various federal, state and other laws that need to be complied with.  After purchasing the loans from its bank partners that it helps originate, Affirm then collects and earns interest and servicing fees from these loans. Since consumers are never charged deferred or compounding interest, late or other fees, the company is not incentivized to profit from consumers’ hardships.

Breakout of Affirm’s Q4 FY2021 Revenue Sources

Affirm will also sell loans that it purchases to various loan buyers and securitization investors. As shown above, gains on sale of loans were 16% of total sales in the latest quarter, well above the company’s average of ~8% of sales. The rise in gains on loan sales was driven by an increase in securitization transactions. A key component of Affirm’s success is its efficient capital deployment, as the company is not dependent on one source of capital. By selling its loans via securitization, it is able to recycle the capital into more loans, generating more fees and revenues.

Attesting to Affirm’s capital efficiency, the company’s required capital has fallen as a percentage of total platform loans over time (shown below). The lower amount of capital Affirm has to hold, the more loans it can make, increasing its revenues and improving its efficiencies. Furthermore, the company focuses on short duration loans, which creates a multiplier effect on Affirm’s committed capital. The short duration loans and numerous sources of capital allows funding to be recycled quickly which lets Affirm to increase its transaction volumes.

Affirm’s Platform Portfolio and Funding Mix

Affirm’s recent results: accelerating growth and improving credit metrics

Affirm reported 9/09/21 and disclosed that Q4 FY2021 sales had grown 71% YOY to $262 million, an acceleration from the 67% and 57% YOY growth rates in Q3 and Q2, respectively. Sales also beat estimates by $37 million, attesting to the rapid growth of BNPL payment methods. Shortly before earnings were released, the company had announced a partnership with Amazon, which is not yet live and did not contribute to the acceleration in sales.

Rather, the acceleration in sales was driven by a rapid rise in gross merchandise volumes (GMV). As shown in the chart below, GMV grew 106% YOY to $2.5 billion, an acceleration from the 83% and 55% YOY growth rates in Q3 and Q2 respectively. CEO-founder Max Levchin explained during the Q4 Earnings call that 38% of GMV was from 0% APR products, down from 54% in the prior year, while 62% of GMV was interest bearing. He explained that the shift was due to the type of transactions, as travel categories rebounded and generally have lower rates of 0% APR products. Customer concentration has also improved, as Peloton declined from 32% of GMV to just 9% of GMV in the current quarter.

Merchant data trends have also improved. Active merchants, which are merchants that have transacted at least once on Affirm’s platform over the last twelve months, increased to 29,000, up from 5,700 in the prior year. The acceleration was largely driven by Affirm’s recent partnership with Shopify, which makes Affirm available to all Shopify merchants in the U.S. With the potential for Amazon to onboard Affirm in the near term, and the Shopify partnership still ramping, active merchants should continue to rapidly grow going forward. Similarly, active consumer count increased 97% YOY to 7 million while transactions per customer rose 8% YOY to 2.3 per customer.

The strong results flowed in guidance. Specifically, Q1 FY2022 GMV is expected to increase 67% YOY to $2.5 billion, while sales are expected to increase 41% YOY to $245 million at the mid-point. For the year, GMV is expected to rise 52% YOY to $12.6 billion while sales are guided to be $1.8 billion at the mid-point. Importantly, management’s guide is conservative, as it does not include benefits from the roll out of the debit+ card (which lets Affirm capture fees from merchants not on its platform) nor does the guide include any revenues from the recently announced Amazon partnership. These two events will likely be material to sales, which may lead to growth rates above management’s initial guide.

Continuing down the income statement, revenues after transaction expenses, increased 37% YOY to $148 million, which was well above management’s initial guidance of $80 million to $85 million. As a percentage of GMV, revenues less transaction expenses grew to 6% of GMV, or 200 bps above the two-year average. The growth in the capture rate of GMV highlights how Affirm’s operations are improving, as the company’s revenues are scaling faster than expenses.

To be complete, Affirm’s bottom-line missed the consensus estimate after the company reported an EPS loss of $0.47, wider than the Street’s expectation by $0.23. The large miss was mostly driven by non-cash expenses such as stock based compensation and warrants issued to Shopify in conjunction with their commercial agreement. Absent these non-cash expenses, adjusted operating income was $14 million, down from $47 million in the prior year.

The company’s credit metrics have also improved during the quarter, however we need the 10K to make a full assessment, which has yet to be released. Based on what’s been disclosed so far, Affirm’s credit quality has improved, which is impressive considering the rapid growth in GMV and sales. It is great to see that Affirm’s rapid growth is also high-quality, as Affirm is not taking on increased risk to grow its topline.

For instance, Affirm is well reserved for potential credit losses. Its allowance for loan losses increased 24% to $118 million, which was well above the trailing twelve month charge off rate of $55 million. Sated differently, Affirm has reserved for ~2.1 years’ worth of charge offs, up from ~1.3 years of reserves in the prior year. The higher rates of reserves lowers earnings by driving up provisions, but provides downside protection if defaults start to pick up. In other words, Affirm’s financials are more conservative than prior years, a positive trend.

Furthermore, provisions for loan losses have outpaced net charge offs. Provisions for loan losses are management’s estimates of future charge offs and provisioning at a faster rate than charge offs is conservative and provides downside protection. Affirm provisioned for $25 million of loan losses during Q4, or 103% of Q4 charge-offs, and on a TTM basis, provisions were 121% of net charge offs.

We can also see that charge-off rates have been improving, meaning that fewer consumers are defaulting on Affirm’s loans. As shown below, Affirm’s net charge off rate has materially declined since 2018 and was around 1.5% of total loans when Affirm went public. As of the latest quarter, Affirm charged off $25 million loans, or 1.3% of total loans outstanding, highlighting that credit quality has continued to improve since the IPO. The I/O Fund believes that Affirm’s acceleration in GMV and sales coupled with an improvement in credit quality warrants a premium valuation.

Valuation and conclusion

Affirm currently trades at a P/S multiple of 29x, below its most direct peer, Afterpay, which trades at a 40x P/S multiple. Afterpay grew its FY2021 sales by 98% YOY, faster than Affirm’s 71% YOY growth rate, which may explain the higher valuation. However, it is noteworthy that Afterpay’s credit quality deteriorated during the year as credit impairment expense rose 106% YOY while Affirm’s provisions declined 36% YOY during FY2021.

Relative to the legacy card issuers such as Visa and Mastercard, Affirm’s P/S ratio is just ~34% above their P/S multiple of 22x and 21x, respectively. Importantly, Affirm is growing much faster than Visa and Mastercard. For example, Affirm grew its topline by 71% YOY in the most recent quarter, which was above the 27% and 36% YOY growth rates for Visa and Mastercard in their most recent quarters, respectively.

As discussed above, Affirm has ambitious plans to disrupt the consumer credit industry, and its opportunity is massive. The company has a strong management team that has resulted in key partnerships with Shopify and Amazon. Growth has recently accelerated and credit metrics have also improved. The firm trades at a premium valuation, which is warranted considering its strong management team, growth and solid credit metrics. There are also favorable microtrends that should benefit Affirm going forward, such as the continued rise of e-commerce and younger generations’ aversion to legacy financial products such as credit cards. Looking forward, management provided strong guidance that did not include potential topline benefits from its recent Amazon partnership nor the roll out of the debit+ card, suggesting that growth will be higher than the initial guide. The company is well positioned to disrupt a very large market and Affirm is just getting started.

 

Disclosure: The I/O Fund own shares in Affirm and does not have plans to change its position within the next 72 hours. You can access the I/O Fund’s positions here. The above article expresses the opinions of the author, and the author did not receive compensation from any of the discussed companies